Operational Due Diligence-Key to M&A Success Igor Zax, CFA, Sloan Fellow (LBS) Managing Director- Tenzor Ltd © Tenzor Ltd 2009-2011 www.tenzor.co.uk

What is operational due diligence? Just one side? ODD-Multi Dimensional Picture Legal Accounting Target We need not only answer “what” but “why” and “what does this mean?” © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Operational Due Diligence-core questions to answer Re-construct the link between the numbers and physical process Do not limit your conversation to finance people- they talk about numbers, not the business Speak to sales, procurement, manufacturing- and reconcile what you hear to what you see in the numbers Understand external environment- suppliers, customers, distributors- they may tell you a lot of things you would not hear from the company Visit the warehouse and manufacturing and ask few simple questions © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Practical Example- What Can you find in a warehouse PCBA PCB What Do you see in Warehouse? Two similar boards (one of which is PCB and one is assembled) are on the warehouse shelf What do you see in Accounts? Working Capital problems What do you see in Manufacturing: Delays, quality issues What do you see in Customer Service Quality Issues © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Question to ask – Why? And Is there a link? The company is buying printed circuit board from a small supplier with advance payment They have no way to properly do QC before assembly They send the board for assembly to another far away provider When they finally got the board back, they find not all of them pass testing. Complex process to find out whose fault (from the two suppliers) it is. What we discovered – WRONG SUPPLY CHAIN causing the problem © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Industry structure and Supply Chain Global industry structures changed massively Platform companies "Produces nowhere but sells everywhere... know where the clients are and what they want and where the producers are. Platform companies then simply organise the ordering by the clients and the delivery by the producers (and the placing of their logo on the product just before delivery).“- GaveKal Integrated and collaborative supply chains. Contract manufacturing, outsourcing, muli-tier distribution Changed structures are often ignored by analysts © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Supply Chain- Distribution of Risk and Reward Customers! Component Manufacturers Component Distributors Contract Manufacturers OEM Distributors VARs Understanding the supply chain is core to determining the future of the company. How is wealth and risk distributed? What is outsourced to whom? Who does financing- is the company a bank? Should it be? What is overall health of the chain, distribution of rewards and risks at particular layer or just company specific issues? Do company numbers represent “steady state” or a time specific state of the chain Who can “shortcut” the chain and what would be consequences? © Tenzor Ltd 2009-2010 www.tenzor.co.uk

Supply Chain-Value Chain Implications Split of value within value chain may change, and current split may be caused by a number of reasons Creating a short term spike in value (that would only last for the time for the rest of the chain to adopt) may boost the numbers, but eventually may be devastating for the business Longer chains have more complex dynamics – analysing multi-tier chain with the tools designed for a single tier (i.e. Suppliers and Customers) lead to wrong results © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Supply Chain-Working Capital Implications One can move working capital and risk up and down the chain at a price. You can almost always add an intermediary that improve any component of your working capital (A/R, Inventory, A/P) at a price (for example pay you at 30 days and collect from their customer’s at 90 days). There are component trade offs (inventory against A/R or A/P). Analysing working capital without understanding of supply chain structure is confusing © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Working Capital- Good Starting Point for ODD Most of the problems of companies manifest themselves in working capital (A/R, Inventories, A/P) Aged debtor list and its analyses vs. sales Are receivables real? Is ageing real ? Why payments are late – disputes vs. credit? Are sales real? What happened prior to sale? Sale is converting inventory to A/R showing a profit. Did it Push the problem next level? Chanel overstocking? Produce uncollectable A/R Is there actual end user demand? © Tenzor Ltd 2009-2010 www.tenzor.co.uk

Working Capital Analyses –cont. Analysing late payments allows to uncover issues with quality, logistics, systems, etc. –credit management is the best source of information about the company issues A/P Short terms – why terms are not offered? May be wrong supplier, no insurance cover, bad history? Long terms –are these sustainable? Overdues- would these be tolerated? Key question – are suppliers still supplying or they already or about to stop? May be significant cash outflow post acquisition. © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Working Capital Analyses- cont Inventory Clear distinction between finished goods, components and work in progress Obsolescence Components for wrong models? They may be perfectly good but perfectly useless Is there a process for managing inventories? Overreliance on ratios- these are just averages “Good” DSO may be a mixture of prepayments and massive overdue “Good” DIO may be a large pile of useless stuff and a massive shortage of needed inventories “Good” DPO may be a mixture of pre-paid suppliers and the ones who already stop supply and looking for legal action © Tenzor Ltd 2009-2011 www.tenzor.co.uk

CAPEX/ Development Costs EBITDA focus creates a strong incentive to under invest Company can run on close to zero CAPEX and even maintenance for a while – but this would mean massive cost in the future Cutting R&D improves short term profitability but negatively affects future cash flows. Cutting people improves profitability but in many business this is the main asset. Particularly relevant for industry buyers- often overestimating own ability to develop/support © Tenzor Ltd 2009-2011 www.tenzor.co.uk

© Tenzor Ltd 2009-2011 www.tenzor.co.uk Processes Assets are not enough –there should be a process for business to run If one thinks of outsourcing (either manufacturing or service) one needs to have a n efficient process in the first place Efficient and well documented process can be “portable”- i.e. Moved to different location etc. If the “process” is based on a “fire fighting” skills it is not only inefficient, but not “portable” One needs to understand what they are buying – “whole business” or its part (for example sales team or R&D capability) If part of the business is not needed, what would it cost to liquidate and would this adversely affect the “desired” part. © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Value is in the eyes of the beholder Type of due diligence would depend on type of the buyer Financial investor needs to look if the business is going to perform in its current form- this becomes focus of the due diligence Strategic (industrial) investor looks if the business would fit/add value to it – this changing the operational due diligence process And type of the seller Understanding seller motivation and way of operating Spin offs- are these truly autonomous? And how they can fit? What do their numbers reflect in reality? PE –the buyer is dealing with professional seller Emerging markets – can company operate being managed by investor that have to comply with Bribery Act (UK), FCPA (US) or other regulatory or ethical requirements? © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Why Vertical Integration? Recent years show a global trend to “platformisation” This was driven by lower transaction costs, supply chain coordination and general low risk environment This is changing now, as risk is again high on the agenda, and transaction costs are up Deals start coming small and very large Cost of acquiring supply chain partner may be lower than switching cost Resolving of concentration problem- getting away from excessive dependencies. A lot of supply chain optimisation techniques designed for a “risk free” world In a risky world it is cheaper to have a solution within a firm- the very reason firms exist (Richard Coase, Nobel price in economics 1991) © Tenzor Ltd 2009-2011 www.tenzor.co.uk

Vertical Integration- Working Capital Implications Buying a week player up the chain- moving from concentrated non- financeable receivables book to diversified Merged company can finance receivables- target on its own find it difficult because of operational risks. Inventories – can be managed down on elimination of bullwhip effect and reduction of safety stock to cover supply risks Payables. If target facing withdraw of lines from suppliers or credit insurance, restoring of these can provide immediate working capital boost. Conclusion: Working Capital may change tremendously in a successful acquisition, providing cash boost instead to cash drain to acquirer. Due diligence needs to find out if this is a feasible option © Tenzor Ltd 2009-2011 www.tenzor.co.uk

© Tenzor Ltd 2009-2011 www.tenzor.co.uk Conclusions Beware of supply chain structure Working Capital is one of the best places to start due-diligence Focus due diligence on what do you want to do with the company Understand the seller motivation- this would help to see the key areas of focus. © Tenzor Ltd 2009-2011 www.tenzor.co.uk

© Tenzor Ltd 2009-2011 www.tenzor.co.uk Thank You and Good Luck! Igor Zax, CFA, Sloan Fellow (London Business School) Managing Director, Tenzor Ltd. (London) Tel: +447775708426 E-Mail: igor.zax@tenzor.co.uk Web site: www.tenzor.co.uk © Tenzor Ltd 2009-2011 www.tenzor.co.uk